Overview
The ATO released new draft guidance relating to the allocation of professional firm profits on 1 March 2021. The Draft Practical Compliance Guideline PCG 2021/D2 (the Draft PCG) explains how the ATO intends to assess the tax risk of individual professionals who operate professional practices and how they will allocate their compliance resources towards these professional individuals. The PCG is proposed to apply from 1 July 2021.
Prior Rules & Transition
The Draft PCG details that the ‘old’ guidance materials (which were suspended on 14 December 2017) will continue to have effect until 30 June 2021 for arrangements entered into prior to 14 December 2017. There is also further transitional period for arrangements entered into prior to 14 December 2017 until 30 June 2023. Effectively, if you have an ‘old arrangement’ the commencement date that should apply is 1 July 2023 (the 2023/24 income year).
Applying the PCG
The draft PCG specifies that you need to pass through two key gateways to use the framework. If you do not pass both these gateways you cannot use the risk assessment factors.
Gateway 1 — Commercial Rationale
The business structure’s design, and the way profits are distributed must be based on commercial terms. The Draft PCG sets out the various conditions to consider in reviewing the commercial substance of professional firm structures.
Gateway 2 — High-risk Features
The arrangement must not contain any of the following ‘high-risk’ features:
- those covered by a Taxpayer Alert;
- financing arrangements relating to non-arm’s length transactions;
- exploitation of the difference between accounting standards and tax law;
- arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland; and
- multiple classes of shares and units held by non-equity holders.
If you pass both gateways then you proceed to apply the risk assessment framework.
Risk Assessment Framework
The risk assessment framework uses the three criteria that were contained within the ‘old’ professional firm guidance material. It generates a score for each criterion for the professional and then calculates a total score to assess the person as either low, moderate or high risk.
| Risk Assessment Factor | Score | |||||
|---|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | 6 | |
| Proportion of profit entitlement from the whole of firm group returned in the hands of the Individual Professional Practitioner (IPP) | >90% | >75% to 90% | >60% to ≤75% | >50% to ≤60% | >25% to ≤50% | ≤25% |
| Total effective tax rate for income received from the firm by the IPP and associated entities (levies excluded – eg. Medicare Levy) | >40% | >35% to 40% | >30% to ≤35% | >25% to ≤30% | >20% to ≤25% | ≤20% |
| Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm | >200% | >150% to ≤200% | >100% to ≤150% | >90% to ≤100% | >70% to ≤90% | ≤70% |
The Draft PCG gives detailed examples of how to calculate each of the percentages required to score each risk assessment factor. It is not something which can be ‘guesstimated’ and needs to be properly worked through to be confident of the result.
Once the scores have been calculated, the table below shows the risk level that the ATO will have assessed to the professional.
| Risk Zone | Risk Level | Aggregate Score of First Two Factors | Aggregate Score of All Three Factors |
|---|---|---|---|
| Green | Low | ≤ 7 | ≤ 10 |
| Amber | Moderate | 8 | 11 or 12 |
| Red | High | ≥ 9 | ≥ 13 |
Consequences of Risk Level
| Assessed Risk Level | ATO Treatment |
|---|---|
| Green | Compliance resources to only be applied in exceptional circumstances |
| Amber | Likely ATO will conduct further analysis of arrangements May contact taxpayer to resolve areas of difference |
| Red | ATO review likely as a matter of priority Case may proceed directly to audit ATO likely to use formal powers for gathering information |
Example
Bebe is a director of a law firm which operates through a company structure and employs a total of 25 staff. She is paid a wage of $180,000 which is the commercial benchmark. A discretionary trust which she controls owns 1/3 of the shares in the company. The profit of the company after all wages is $660,000 on which tax is paid and the balance paid to the shareholders as a fully franked dividend. Bebe’s discretionary trust distributes its franked dividend to a company which she controls.
The overall profit entitlement of Bebe from the group would be $400,000 ($180,000 of wages plus a $220,000 grossed up franked dividend).
| Factor | Score | Reasons |
|---|---|---|
| 1 | 5 | Bebe’s entitlement is less than 50% ($180,000 / $400,000) |
| 2 | 3 or 4 | the average tax rate will be 30.02% if Bebe’s company has a 30% tax rate, but 27.82% if Bebe’s company receives the 26% company rate. This depends on what other income the company earns |
| 3 | 4 | Bebe’s income is 100% of the commercial benchmark |
Overall, the score is either 8 (moderate risk) or 9 (high risk) using the first two factors or 12 (moderate risk) or 13 (high risk) using all three factors. Under the ‘old’ guidelines Bebe would have been considered low risk. Now, if her company is taxed at the lower 26% rate she is likely to be reviewed or audited and may be subjected to the ATO formal information gathering powers.
Example with Altered Fact
All facts are the same as the above example except instead of Bebe being a lawyer she is an electrician. The Draft PCG does not apply and there are no factors that indicate Bebe will have ATO compliance resources directed at her.
Is this the Law?
The short answer is ‘no’. A PCG is not a legally binding document in the way a public ruling is. It is a statement of the ATO’s risk approach and informs taxpayers of how they intend to apply their compliance resources. This is only a Draft at this stage.
Is this a good Risk Approach?
On one hand, if this is the way the ATO is assessing risk then it is helpful to understand where you fit in their assessment. Taxpayers and their advisors can perform their own calculation and sleep easy where they are in the green zone. Where they are in the red zone, they have the opportunity to make changes to their arrangements and move to a lower risk score.
However, this is only a good approach where the scores both identify taxpayers engaging in high-risk behaviour (based on the actual law) as high risk and those engaging in low-risk behaviour (based on the actual law) as low risk. In our view, the tool as developed is based on fundamental principles which have no actual basis in law as to how the income of professional firms should be taxed. Applying the PCG assesses many individuals as high risk where there is no real risk at all. It also assesses as low risk many taxpayers who engage in high-risk activity.
Feedback on the Draft PCG closes 16 April 2021. There are many concerns being raised in the feedback provided to the ATO. CPA Australia, Chartered Accountants Australia & New Zealand, Institute of Public Accounts, the Business Law Section of the Law Council of Australia and The Tax Institute have published their joint feedback which rejects the foundational principles that explicitly and implicitly underpin the Draft PCG.
What Should I do?
You should be informed as to the current Draft which has been published and discuss the issue with your professional accountant as to what action you might take. Hoffman Kelly can assist with the calculation of your risk assessment score. If the Draft PCG is finalised in this form it is a significant change and will require much adjustment to current arrangements.
